## Example 1710

THE SHORT- AND LONG-RUN AGGREGATE CONSUMPTION FOR SRI LANKA, 1967-1993

Suppose consumption C is linearly related to permanent income X*:

Since Xt is not directly observable, we need to specify the mechanism that generates permanent income. Suppose we adopt the adaptive expectations hypothesis specified in (17.5.2). Using (17.5.2) and simplifying, we obtain the following estimating equation (cf. 17.5.5):

As we know, p2 gives the mean response of consumption to, say, a \$1 increase in permanent income, whereas a2 gives the mean response of consumption to a \$1 increase in current income.

From annual data for Sri Lanka for the period 1967-1993 given in Table 17.5, the following regression results were obtained47:

where C = private consumption expenditure, and X= GDP, both at constant prices. We also introduced real interest rate in the model, but it was not statistically significant.

The results show that the short-run marginal propensity to consume (MPC) is 0.4043, suggesting that a 1 rupee increase in the current or observed real income (as measured by real GDP) would increase mean consumption by about 0.40 rupee. But if the increase in income is sustained, then eventually the MPC out of the permanent income will be p2 = yP2/y = 0.4043/ 0.4991 = 0.8100 or about 0.81 rupee. In other words, when consumers have had time to adjust to the 1 rupee change in income, they will increase their consumption ultimately by about 0.81 rupee.

 Observation